Partners in Debt

Hooray! Turns out America is not the only naughty western nation irresponsibly over-indebted. Our friends the Brits are similarly slovenly—their debt now exceeds their GDP!

Record Numbers Face Debt Meltdown
By Edmund Conway, Telegraph

Might as well ship the entire country to debtor's prison. (Isn't that how we got Australia in the first place?) But is that much debt bad? How can you tell when your debt level becomes "too much?"

Here's an easy way to think about it. If you have a mortgage, you likely owe several multiples more than your yearly income. (If you live in the San Francisco Bay Area, you owe many multiples more than your yearly income.) You'd be in big trouble if someone showed up at your door demanding full repayment by the end of the year. But that's not how your mortgage works—many folks amortize payments over 30 years. Many others have five-, seven-, and ten-year mortgages, and when they get to the end of the term, they can just roll over the debt. If they can afford the debt payments, who are they hurting? The point is, it's irrational to imagine the UK or the US is going to have to "pay back" all their debt this year. Or ever.

The subprime hoopla has reignited investors' fear of debt. We have too much debt as a nation—even the UK is in dire straits—and all this debt is going to slow the economy. Right? Super wrong. In fact—just the opposite. If investors can sidestep their emotions and rationally consider debt the way a CFO would, they'd see the US is actually shockingly underindebted. (And the UK too, probably.)

Yes, the US has a lot of debt, about $8.6 trillion—a whopping 66% of our GDP (Ha! Less than the Brits.) Most folks would say we should reduce that—maybe entirely. But most (rational) investors can recognize debt is used responsibly and profitably by perfectly respectable S&P 500 companies. So maybe zero debt isn't a goal, but how much is right?

Checking our handy Microeconomics text book, we see profit maximization occurs when marginal costs equal marginal revenue. So, the goal is to have your borrowing costs just equal your return on assets. If you do that, you've borrowed enough to buy as many assets to profit from, and no more. At that point, more debt would be bad, and less debt would be bad—the porridge is just right. So where does the US stand?

Lumping together all forms of borrowing, it's safe to assume a 6% borrowing rate, which is 4% after-tax. (Yes, credit card debt has higher rates. But believe it or not, outstanding credit card debt is small percentage of total debt when you add in mortgage debt, corporate debt, financial sector debt, federal debt, etc.—all at much lower rates.) A visit to the Federal Reserve web site tells us America has assets totaling $111 trillion and our GDP is about $13 trillion—giving us an approximately 12% return on assets. Last we checked, 12% was a lot higher than 4%, meaning we are provably underindebted (as we mentioned yesterday in "Grumpy Journos, Happy Market"

From this point, less debt would be bad, but more debt would mean more profit-producing assets and greater wealth societally. Greater wealth is awesome! We're sure the UK is in a similar predicament, making their bigger relative debt a good thing, not something to mock or induce banishment. Mind you, we are not advocating that everyone run out and max out their credit cards. That's not an efficient form of leverage. And yes, there are some folks who do get in trouble with debt, but no matter what you hear on 60 Minutes, it's not the vast majority of Americans.

As we've pointed out in this space before, investors are failing to scale subprime properly, and it won't have the economic impact many fear. To review our thoughts on subprime and the "credit crunch," read:

• No Credit Messiah Necessary 
• Blood in the Alleys 
• Best Credit Crunch Ever 
• They'd Rather Be in the Casket 
• Pray for Panic

Investors who fear our big and growing debt burden have it backwards. They are missing the power of leverage as an economic driver. The worse thing we could possibly do at this point is enact some legislation aimed at reducing debt. (Andrew Jackson learned that the hard way, paying off all of America's debt in the 1830s—and then watching the Panic of 1837 lead into the Depression of 1837 to 1843—one of the most severe in our nation's history.)

Our big debt is nothing to fear. Neither is the UK's. Bully for them.